The Federal Open Market Committee (FOMC) released its latest statement on monetary policy on September 20, 2017. Whereas everyone was talking about interest rates before, now we have a second issue.
For interest rates, which is the target federal funds rate, the target will remain the same for now, which is between 1% and 1.25%. The Fed has been controlling this rate by paying interest to banks on required and excess reserves. Even though the target rate will remain the same for now, there is an expectation that this rate will go up another one-quarter percent in December.
The bigger news is the Fed’s balance sheet. Starting in October, the Fed will begin what is referred to as a “balance sheet normalization program”.
In the FOMC’s implementation notes, the details are spelled out. The Fed will only roll over maturing debt after it exceeds a certain amount. Starting in October, it will be $6 billion for Treasury debt and $4 billion for mortgage-backed securities. In total, the Fed will stop rolling over $10 billion in debt each month. In other words, the Fed’s balance sheet will be reduced by approximately $10 billion each month.
This reduction should increase if the Fed sticks by the description from the June 2017 statement. If it continues on course, it will eventually be draining its balance sheet by a total of $50 billion per month. When this ends, nobody knows.
Of course, if economic conditions change significantly, it could easily impact this whole process of balance sheet normalization.
Despite Janet Yellen’s reputation as a Keynesian, she has been far better than Bernanke up to this point. This isn’t saying much though, because Bernanke didn’t do much until the financial crisis hit. That is when he turned up the digital printing presses.
QE3 ended in October 2014, shortly after Yellen took office. We have seen very little monetary inflation from Yellen’s Fed. Still, this is after a period of unprecedented monetary inflation (2008 to 2014).
It is important to realize though that we are about to see actual monetary deflation, assuming the Fed follows through with what the FOMC statement says. While the Fed will not actually have to sell off its assets, it is essentially doing the same thing by not rolling over maturing debt. It is not clear how the Fed will get rid of its mortgage-backed securities, since so much of this was bad debt to begin with.
Based on this policy, we should see the monetary base and corresponding balance sheet go down. This is monetary deflation. It does not mean we have to see consumer price deflation.
You have to wonder how long all of this will last though. It has been 9 years since the worst of the financial crisis became apparent. There has been huge monetary inflation, but not huge consumer price inflation. We have seen asset price inflation, especially when it comes to stocks.
The Fed handed stock investors a gift. For people who bought in March 2009, they really got a gift. They would be wise not to be too greedy.
The Fed will also take it all away. If the big rise in U.S. stocks is primarily due to the Fed’s loose monetary policy, then we should not be surprised when a deflationary policy takes it all away.
Things take time to play out. Investors have been expecting this announcement for a while now. Investors also know that the Fed still stands as the lender of last resort in any kind of crisis.
The stock rally may last longer before heading down. It is hard to bet against a rising market. At the same time, the Fed’s new policy of monetary deflation should send warning signals to those who own stocks. What the Fed has “given” us, it will also take away.